What is Leverage Ratio?
For any business, securing funding is a tall order. When it comes to doling out money friends, families, venture capitalists, banks, etc. all have their own standards and skepticisms involved. If you are in business and need financing, you would need to understand a few key metrics that determine your financing situation, one of them being leverage ratio.
For businesses and banks, leverage ratios are a useful indicator to gauge how their assets are financed. One can gauge how much capital is coming from debts (loans) or equity. How well a company can meet its financial obligations can be understood by looking at its leverage ratio, hence it is a useful metric for investors and market analysts. But what is leverage ratio?
Let us take a closer look at leverage ratios and their importance, learn the leverage ratio formula, and also find out what is an ideal leverage ratio for banks and other types of industries.
What is Leverage Ratio
The proportion of debt or loan to equity or capital gives the financial leverage ratio of any company. Banking institutions often use the capital leverage ratio to track finances. Businesses also use this metric to show the level of debt compared to their accounts, for instance, cash flow statements, income statements, or balance sheets.
Leverage ratios are a set of ratios that showcase a company’s financial leverage with respect to assets, liabilities, and equity. It is the proportion of debt to cash and assets.
If the leverage ratio is high it means that the firm is using debt to finance its operations and assets. This is a telltale sign of a risky bet for potential investors.
A high leverage ratio also shows that the earnings of the entity could be inconsistent. Shareholders will have to wait for a while before they can get a return on their investments.
Another possibility of a high leverage ratio is the company soon becoming insolvent.
Creditors use the leverage ratio to decide if they could extend their credit to the firm or not.
A financially responsible organization with a steady flow of revenue would have a lower leverage ratio. This shows credit agencies and shareholders that the firm poses minimal risks and is worth an investment.
Calculating Leverage Ratio
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There are many different types of leverage ratios under the financial leverage ratio umbrella that investors and market analysts consider for deciding upon a company’s financial stability. There are primarily six financial leverage ratios, each having its separate leverage ratio formula which is outlined below:
Debt ratio - This shows how much of a business’s assets (like real estate, property, etc.) are coming from loans. Another name for this ratio is the debt-to-assets ratio. The formula of debt ratio is given by “total debt/total assets” and a debt ratio of 0.5 is considered a good measure. A company is said to be at high financial risk if its debt ratio is more than 1.
\[\textrm{Debit Ratio}=\frac{\textrm{Total Debit}}{\textrm{Total Assets}}\]
Debt-to-Equity ratio - This ratio shows how the firm’s equity stacks up against its liabilities. This is different from the debt ratio as it uses total equity as opposed to total assets in the leverage ratio formula. The debt-to-equity ratio helps lenders understand if most of the company’s operations are financed by equity or debt. The formula of this ratio is “total debt/total equity” and a good debt-to-equity ratio is anywhere between 1 to 1.5 (figures vary based on the industry). A ratio of more than 2 is considered risky. Some companies need huge amounts of funding to maintain their operations, for instance, manufacturing companies. These companies would usually have a higher debt-to-equity ratio.
\[\textrm{Debit - to - equity Ratio}=\frac{\textrm{Total Debit}}{\textrm{total equity}}\]
Debt-to-Capital ratio - The formula for this ratio is “total debt/(total debt + total shareholder’s equity)” and is used by investors to determine their risks of the investment in any company. Total capital is the sum of all the company's debt and shareholder’s equity.
\[\textrm{Debit - to - Capital Ratio}=\frac{\textrm{Total Debt}}{\textrm{total Debt + total shareholder's equity}}\]
Debt-to-EBITDA ratio - The full form of EBITDA is Earnings before interest, taxes, depreciation, and amortization. EBITDA is useful to companies for giving them a clear picture of their cash flow and overall financial health. A low Debt-to-EBITDA ratio denotes a manageable debt load of the company. The acceptable range of this ratio varies from industry to industry so it is best to compare the Debt-to-EBITDA ratio of your business with other businesses that are of similar nature.
\[\textrm{Debit - to - EBITDA Ratio}=\frac{\textrm{Total Debt}}{\textrm{EBITDA}}\]
Asset-to-Equity ratio - The total assets of your company that are funded by the shareholders is measured by the asset-to-equity ratio. Shareholder’s equity can comprise minor interest, preferred stock, or company stock. If this ratio is low it means that your firm has selected conservative financing and has a minimal amount of debt. A high ratio denotes high debt and lenders would refrain from providing additional financing to such companies.
\[\textrm{Asset - to - Equity Ratio}=\frac{\textrm{total asset}}{\textrm{total equity}}\]
Operating Leverage ratio - If you want to gain insights into a business’s fixed and variable costs, then you would look at its operating leverage ratio. If this ratio is high it means that the firm has a lower percentage of variable costs and high fixed costs. In such a case an increase in revenue would improve the company’s bottom line. The below formula is used to calculate the operating leverage ratio:
\[\frac{\textrm{(Price - Variable cost of each unit)*(quantity)}}{\textrm{(Price - Variable Cost of each unit)*(quantity) - fixed operating costs}}\]
Hence, this well-written article has covered every vital detail concerning the leverage ratio.
FAQs on Leverage Ratio: Meaning, Types, and Calculation
1. What is a leverage ratio in financial terms?
A leverage ratio is a key financial metric used to evaluate a company's level of debt compared to its assets, equity, or earnings. It essentially measures how much capital comes in the form of debt (borrowed funds) and is used by investors and analysts to assess a company's financial risk. A higher ratio generally indicates greater reliance on debt and therefore, higher financial risk.
2. What are the primary types of leverage ratios used in business finance?
There are several types of leverage ratios, each providing a different perspective on a company's debt. The most common ones include:
- Debt-to-Equity Ratio: Compares a company's total liabilities to its shareholder equity.
- Debt-to-Asset Ratio: Measures the percentage of a company's assets that are financed through debt.
- Debt Service Coverage Ratio (DSCR): Evaluates a company's ability to pay its current debt obligations using its operating income.
- Financial Leverage Ratio: Measures the extent to which a company's assets are financed by equity.
3. How do you calculate the Debt-to-Equity ratio, and what does it signify?
The Debt-to-Equity ratio is calculated using a straightforward formula: Debt-to-Equity Ratio = Total Debt / Shareholder's Equity. This ratio signifies the proportion of company financing that comes from creditors versus what comes from its own shareholders. A ratio of 1.0 means creditors and shareholders have an equal stake in the company's assets. A higher ratio indicates that the company is more aggressively financed with debt, which can magnify profits but also increases risk.
4. Can you provide a simple example of calculating a leverage ratio?
Certainly. Imagine a company, 'ABC Ltd.', has Total Debt of ₹5,00,000 and Shareholder's Equity of ₹10,00,000. To find its Debt-to-Equity ratio, you would divide the total debt by the shareholder's equity:
₹5,00,000 / ₹10,00,000 = 0.5.
This 0.5 ratio means that for every ₹1 of equity, the company has ₹0.50 of debt. This is generally considered a low-risk level of leverage.
5. Why is it so important for investors to analyse a company's leverage ratios?
Investors analyse leverage ratios to gauge the financial stability and risk profile of a company. A high leverage ratio might indicate that a company is over-extended and could be vulnerable to bankruptcy if its profits decline. Conversely, a very low ratio might suggest it is not taking advantage of the potential to increase profits through financial leverage. It provides critical insight into how a company finances its operations and its ability to meet its debt obligations.
6. What is the fundamental difference between financial leverage and operating leverage?
The key difference lies in the type of costs they relate to. Financial leverage is concerned with the use of borrowed capital (debt) and the associated fixed financial costs, like interest payments. It magnifies the effect of changes in EBIT on earnings per share. In contrast, operating leverage is concerned with fixed operating costs (like rent, salaries, and depreciation). It measures how a company's operating income changes in response to a change in sales.
7. What are the potential risks for a business that operates with a very high leverage ratio?
A very high leverage ratio exposes a business to significant risks. The primary risk is an increased vulnerability to bankruptcy, as the company must make large, fixed interest payments regardless of its earnings. During an economic downturn, a decline in revenue can make it impossible to cover these debt obligations. Other risks include reduced financial flexibility to pursue new opportunities and difficulty in securing additional financing, as lenders may see the company as too risky.
8. Is a high leverage ratio always a negative indicator for a company?
Not necessarily. While a high leverage ratio signifies higher risk, it can also be a strategic choice to enhance shareholder returns. This concept is known as 'Trading on Equity'. If a company can earn a higher rate of return on its investments than the interest rate it pays on its debt, the excess earnings go to the shareholders, thus magnifying their returns. Therefore, in a growing and stable business, high leverage can be a powerful tool for growth, though it always comes with increased risk.
